By Nik Shahrizal Sulaiman

Lately, the topic of ESG has taken centre stage in our business conversations. From business columns to webinar discussions and social media chatter, many opinions have been shared to describe the urgency of the issue.

But what exactly is ESG and how important is it really to our businesses and specifically the banking sector? For the uninitiated, ESG stands for ‘environmental, social and governance’ and the term is typically used in the context of how a business plays a role in sustainability and how it protects the environment and the community.

In the banking sector, there has been an increased focus on the issue of climate risk within the larger ESG agenda. On 30 April 2021, Bank Negara Malaysia (BNM) issued a guidance document titled Climate Change and Principle-based Taxonomy with the objective of creating a standardised set of classifications and reporting of climate-related exposures to support risk assessments in the banking sector. The intention is that by providing this guidance, it would help the industry to plan the transition towards sustainability and eventually help shift investments where they are most needed.

But how important is ESG or specifically climate risk in the context of the banking sector? Is this just a fashionable buzzword which will disappear when a new trend comes along or does this represent a fundamental shift in terms of how we look at the role and purpose of banks within the wider community? To answer this question, we must first consider this from the perspective of history and science.

The Industrial Revolution

The industrial revolution which started in the 18th century was probably one of the most important events in our modern history. It ushered a new age of prosperity and innovation, unparalleled in the context of economic development. Rapid industrialisation, which began in Britain, gradually expanded all over the world, and with it came rapid consumption of energy such as coal, petroleum and other forms of fossil-based energy.

However, this progress has not been without cost. An unprecedented volume of carbon dioxide has been released into the atmosphere as a result of human activities since the industrial revolution and because carbon dioxide traps heat, this has resulted in the greenhouse effect which contributes to global warming. Many peer-reviewed studies have been published in this area of study, which provide in-depth analyses on the adverse effects of global warming, such as melting polar ice caps, rising sea levels, volatile weather patterns and natural disasters.

Indeed, our country is not immune to this risk. According to various sources cited in the BNM’s Climate Change and Principle-based Taxonomy, Malaysia has experienced an increase in surface mean temperature of 0.13°C to 0.24°C for every decade from 1969 to 2016. In addition, more than 50 climate-related disasters have been reported in the past 20 years, resulting in over RM8 billion in monetary losses and affecting the lives and livelihood of more than three million people in Malaysia through displacements, injuries and death.

Why Should Banks Care about Climate Risk?

Even though the responsibility to protect our environment should not be restricted to a single group of stakeholders, the banking sector nevertheless plays an important role in this agenda. This is because the banking sector provides the economy with capital and consequently, how the capital is directed and managed has a direct impact on how much carbon emissions the economy produces.

In addition, the banking sector’s role in climate risk mitigation is also important to our national aspiration. As a signatory to the Paris Agreement, Malaysia has made a commitment to reduce our greenhouse gas (GHG) emissions by 45% by 2030 (from its 2005 level). On this note, there have been encouraging developments from the Malaysian banking community. Several banks have recently announced the gradual phasing out of financing activities in coal plants, whilst others have committed towards net-zero carbon emissions in the future. Even though these commitments are a step in the right direction, more can be done by our banking industry to take this agenda further.

Tone From the Top and Governance

In order to elevate the climate risk agenda in the banking industry, it is critical for this initiative to be driven at a strategic level and not restricted to certain functions within the bank. As such, it is important to create a robust governance structure to enable the board and senior management to provide adequate oversight over the climate risk agenda. For example, in some banks around the world, climate-related committees are created at the board level to secure board oversight over climate-related risks and opportunities. This oversight is then augmented by a management-level committee made up of experts from various front-office functions, sustainability, risk and other departments. The committees meet frequently throughout the year and climate risk becomes a fixed agenda item during every meeting.

Having a clear and robust governance structure helps the management with the necessary buy-in to drive the agenda throughout the rest of the organisation, which is then cascaded at the operational and business level. Without strong support from the top, such an initiative is likely to be short-lived and lacking in substance. It is also important for organisations to have quality information and relevant metrics to facilitate the decision-making process.

The Importance of Sustainability Frameworks and Disclosures

Currently, there are many guidance and reporting frameworks on the topic of sustainability or ESG. Examples include frameworks and standards issued by the Global Reporting Initiative, the Sustainability Accounting Standards Board, the Climate Disclosure Standards Board, and the Task Force on Climate-related Financial Disclosures (TCFD) among others.

Each of these frameworks has a slightly different focus depending on their objectives. For example, the TCFD was established by the Financial Stability Board in December 2015 to develop climate-related disclosures that “could promote more informed investment, credit [or lending] and insurance underwriting decisions”.  The TCFD recommendations are organised into four key themes covering different areas such as governance, risk management, strategy and metrics/targets, supported by various key climate-related financial disclosure requirements in relation to the areas above.

In the UK for example, the Financial Conduct Authority announced that premium-listed commercial companies are now required to adopt the TCFD reporting for companies with reporting periods beginning on or after 1 January 2021. In addition, the UK Chancellor of the Exchequer, Rishi Sunak also announced that the TCFD-aligned disclosures will become mandatory across the entire economy by 2025.

Even though these frameworks are currently not mandatory in Malaysia, clear benefits can be reaped from early adoption. Firstly, it adds an element of structure to the bank’s ESG or climate risk initiatives. Secondly, it will provide better quality reporting and disclosures to a broad range of stakeholders. Thirdly, given the rate of adoption across the world, it will just be a matter of time before investors and other stakeholders will expect our own banking sector to adopt the TCFD-aligned disclosures as well. Together with the new taxonomy issued by the BNM, these will help our banking sector make a bold transition towards this agenda.

Risk Management, Carbon Metrics and Data

Once a specific framework or standard has been selected, banks can then conduct a gap analysis to assess the areas requiring further enhancements. This may involve relooking at various processes, such as strategy setting, risk management practices, data collection, business resilience and others to ensure that they are aligned with the framework requirements.

For example, on the topic of risk management, the risk appetite statement may need to be refined and updated to formalise the bank’s approach on managing climate risk. Some policy documents may need to be updated to describe the bank’s policy on specific sectors. In addition, climate risk metrics can also be created to measure the carbon footprint across various sectors, with specific targets to reduce the overall carbon emissions in the bank’s portfolio. New sets of data may need to be collected to enable climate risk stress tests and scenario analysis.

Overall, there is a long list of initiatives that can be undertaken by our banking sector to further this agenda, however these need to be coordinated and driven at both the strategic and operational levels to ensure that key objectives are met.

Adapting to the New Paradigm

In conclusion, the climate risk agenda will continue to be an important topic for the banking sector. This is not only driven by a moral imperative to protect the environment. Looking at various trends around the world, the decision towards stronger ESG adoption is also driven by financial, economic and regulatory factors.

As the global economy evolves in line with this new paradigm shift, it is important for our banking sector to relook its business model, adapt to ESG and benefit from the new opportunities that this new paradigm offers.

Nik Shahrizal is a Partner with PwC Malaysia. He holds the CFA and ICAEW qualifications and graduated with an MBA from Judge Business School, Cambridge.